Value in the context of Your Overall Portfolio

A stock's value is the sum of its future cash flows, each discounted to today's value at the base return you're aiming to make.

But that doesn't mean you'd rush straight out and buy stocks at that value - if you did, you'd only expect to make whatever return you'd factored in, and you wouldn't be leaving yourself any margin for error.


Margin of safety

To be interested in the investment, we'd have wanted to see a discount to that fair value, and it's very much a case of the more the merrier.

The larger the discount to your estimate of expected value, 

• the greater the likely returns and 
• the less chance you have of losing money.

So how might the margin of safety work with a stock?

Let's say your expectation is for ABC Company to pay dividends in the current year of $1.20, and that you expect this to increase forever by 6% a year.

• To get a targeted return of 10%, you'd therefore need to pay a price that provided a dividend yield of 4% (so that the yield of 4% plus its growth of 6% would equal your targeted return of 10%), which comes out at $30 ($1.20 divided by 4%, or 0.04.)

Calculations:

$1.20/4% = $30.

Next year, dividend = $1.20 x 1.06 = $1.272
Share price = $1.272/4% = $31.80
Total return = Capital gain + Dividend = ($31.80- $30) + $1.20 = $3
Total return = $3/$30 = 10%.

But that is just your estimate of a fair value for the stock. To get you interested in buying it, you'd need to see a discount to this - and the riskier the situation and the better the opportunities elsewhere, the more of a discount you'd need.

• Balancing it all up, you decide you only really find ABC Company compelling at $20.
• That would give you a 33% margin of safety, but it would also increase your dividend yield to 6% and your total expected return to 12% (the 6% yield plus the 6% growth).

The intrinsic value of $30 is also the level you might reasonably expect the stock price to return to (or 6% higher than that for each year into the future to allow for the growth) - so it also defines the capital gain you're secretly hoping to make if the price returns to the underlying value. 

• The trouble is that you don't know when - or even if - the price will return to that underlying value.  
• But the bigger the margin of safety and the more confident you are about it, the better your chances of capital appreciation.  
• And if you're left holding the stock, a large margin of safety should at least make it a decent ride.

The price wobbles around, either side of the underlying value, and your aim is to buy when it's a good way below it.  

• The further the price gets from the value, in either direction, the more likely a snap-back becomes.  
• Riskier stocks are those that have a wide range of potential outcomes.  They will probably bounce more wildly, making the prospects of a snap-back less reliable, and you'll want to buy at a wider discount to provide some comfort.

Diversification

Even with a fat margin of safety, you wouldn't put too much just in single stock because of a remote and variable chance of a complete wipe-out.

With stocks, diversification comes from spreading your portfolio over a range of different companies and sectors, and from the amount of time you are invested. 

The more time you allow, the greater the chances of the value being reflected - which, of course, is why the sharemarket beats cash more consistently the longer you give it.



Interaction between diversification and margin of safety.

There's an interaction between diversification and margin of safety, because the more you've got of one, the less you might need of the other.

There is, however, a crucial difference:

• as you increase the number of stocks in your portfolio, your selections gradually get worse.  
• An increased margin of safety, on the other hand, will mean better selections.

The flip side is that margin of safety relies on you making correct assessments of value, while diversification will tend to take you towards an average return, whether you're getting the value right or wrong.  

• So if you're very confident in your ability to assess value, you might focus on finding stocks where you see a huge margin of safety and not worry so much if you end up holding only a few of them.  

• But if you're less sure about assessing value correctly, you'll want to focus more on achieving a decent diversification, with the inevitable reduction in apparent margin of safety from your additional selections.

Related:

• Value Investing is about Buying Stocks for less than they're worth
• Simple ways to value stocks and shares
• Value in the context of Your Overall Portfolio